Why FHFA IG report doesn’t mean big new liability for banks

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When I first read the Federal Housing Finance Agency Inspector General’s report criticizing Freddie Mac’s $1.35 billion MBS put-back settlement with Bank of America, I wondered if the FHFA IG had just exposed billions of dollars in untapped bank liability. The IG report notes, after all, that Freddie’s deal with BofA (unlike Fannie Mae’s simultaneous $1.52 billion BofA settlement) resolves not only pending breach of contract claims, but also any future claims that Countrywide breached representations and warranties on the mortgages it sold Freddie. Those are exactly the kinds of global settlements banks are going to have to reach if they have any hope of resolving their MBS put-back liability.

So if the FHFA Inspector General is castigating Freddie for overlooking BofA’s liability for mortgages that defaulted four or five years after they were issued — and FHFA is generally reckoned to be the most experienced evaluator of reps and warranties claims there is — have other put-back claimants underestimated potential bank liability? Are bond insurers and MBS investors making the same supposed mistake as Freddie Mac?

The short answer is no.

The IG report faults Freddie for failing to account for the exotic mortgage loans that proliferated in the housing bubble. Homeowners with interest-only or adjustable-rate mortgages often made it through the early teaser-rate years, only to default when they had to begin making higher payments. The FHFA IG report indicates that Freddie Mac has seen tens of thousands of these mortgages go into default three to five years after they were issued.

That changed the traditional default bell curve, in which deficient mortgages went sour within a year or two and default rates slowed thereafter. But according to the FHFA IG, Freddie never adjusted its process of reviewing defaulted loan files to reflect the changed default model. The government agency continued looking for breaches of reps and warranties in loans that went bad within the first two years after they were issued, even though the exotic mortgages of the housing boom frequently took longer to sour. As a result, the report said, Freddie may have severely underestimated its put-back claims against Countrywide.

“By choosing to review intensively only those loans that defaulted within two years of origination,” the IG report asserts, “Freddie Mac did not examine close to 100,000 2006 vintage loans.Those loans that were not reviewed have a combined unpaid principal balance exceeding $50 billion.” The report cited a senior FHFA examiner who estimated that BofA’s liability for those unreviewed loans could run to billions of dollars, although in a footnote deep in the report the IG quoted a more moderate estimate of $500 million to $1 billion in total additional revenue (not just from BofA) for Freddie if it changed its loan review process to account for later-defaulting mortgages.

It’s too late to undo Freddie Mac’s settlement with BofA, and the IG’s report doesn’t argue otherwise. Instead, it calls for Freddie Mac to revise its mortage loan review process and to assure that senior managers respond quickly and sufficiently to staff concerns.

In fairness to Freddie Mac, there’s a good reason the agency focused its attention on mortgages that went into default quickly. Lenders are usually quicker to accept claims that material breaches in their reps and warranties led to the mortgage’s default if the loans fail right away. In other words, put-back claims on mortgages that went into default within a year or two are the low-hanging fruit of MBS put-back litigation. When homeowners default several years into their mortgage, mortgage issuers are likelier to assert that economic conditions — such as a homeowner losing a job or the decline in housing values — are responsible for the mortgage’s failure. Banks typically argue that they’re only liable to repurchase loans that failed as a direct result of their underwriting breaches. So forcing put-backs of later-defaulting loans is a tougher prospect.

But that doesn’t mean that bond insurers and MBS investors are ignoring those late defaults. To the contrary — they’re fully aware that it takes adjustable-rate mortgages longer to fail. My reporting indicates that if Freddie Mac truly didn’t assert put-back claims against BofA for mortgages that went bad after three years (there’s some doubt about that proposition), Freddie is an outlier. “I can guarantee that MBS investors and monolines aren’t limiting their review,” said one bond insurers’ lawyer. A lawyer for MBS investors added: “If a loan breached warranties on the day of closing and didn’t go into default until three years later, it’s no less in default.” This lawyer, like the monolines’ counsel, said no reasonable put-back claimant is limiting review to mortgages that defaulted within one or two years.

The proof is in the deals BofA has already struck with the bond insurer Assured Guaranty and with the investor group represented by Gibbs & Bruns. Under the Assured deal, BofA is continuing to pay the bond insurer for materially deficient mortgage loans issued in 2006 and 2007 — including loans that defaulted long after 2008 or 2009.

The embattled $8.5 billion BofA settlement with Countrywide MBS investors, meanwhile, explicitly accounted for late-defaulting mortgages, according to Kathy Patrick of Gibbs & Bruns. “The analysis the Inspector General claims FHFA should have done for recent defaults, we did,” Patrick told me. “We captured all loans that were 60 or more days delinquent and specifically analyzed [them].” The expert who opined on the fairness of the settlement amount for Bank of New York Mellon, the Countrywide securitization trustee, described his process of deriving a default rate in a filing BNY Mellon made public in the proceeding to win judicial approval of the proposed deal. The expert, Brian Lin of RRMS Advisors, said he accounted for defaults that occurred all along the timeline, including loans that hadn’t yet gone into default but were 60 days’ overdue. The default rate he used in reaching an estimate that BofA’s put-back exposure is about $9 to $11 billion specifically addressed loans that fell into trouble long after they were first issued.

Even Fannie Mae apparently didn’t limit its review of loan files to early defaults; the FHFA Inspector General was tasked with looking at both the Fannie and Freddie BofA settlements, but flagged only Freddie’s loan review methodology.

Freddie Mac has promised not to reach any additional settlements without considering the IG’s recommendations that it revamp its loan review process. And it shouldn’t. No reason the government shouldn’t do what everyone else already is.

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Alison Frankel updates On the Case multiple times throughout the day on WestlawNext Practitioner Insights. A founding editor of the Litigation Daily, she has covered big-ticket litigation for more than 20 years. Frankel’s work has appeared in The New York Times, Newsday, The American Lawyer and several other national publications. She is also the author of Double Eagle: The Epic Story of the World’s Most Valuable Coin.